Dr. Yukon Huang on Misconceptions on the Chinese Economy.

Yukon Huang is currently a senior fellow at the Carnegie Endowment in Washington D.C. He was formerly the World Bank’s Country Director for China.

Huang's research focuses on China’s economy and its regional and global impact. Huang has published widely on development issues in professional journals and the public media. He is a featured commentator for the Financial Times on China and his articles are seen frequently in the Wall Street Journal, Bloomberg, Foreign Affairs, National Interest and Caixin. His recent books include East Asia Visions, Reshaping Economic Geography in East Asia and International Migration, and Development in East Asia and the Pacific. His latest book Cracking the China Conundrum: Why Conventional Economic Is Wisdom Is Wrong was published by Oxford University Press (2017).

Huang earned his Ph.D. in economics from Princeton University and holds a B.A. from Yale University.

Can you list the three most serious misunderstandings of the Chinese economy in the West and explain why the conventional wisdom in the West has been so wrong?

Before identifying the three misunderstandings, let me note that China's rise has created widespread political and economic tensions with the West. China’s rise affects the West through trade and investment flows and its impact reflects the sheer size of the Chinese economy. Many in the United States are concerned about China because they see its rise as a threat to the liberal international order that the US helped to establish. Current tensions are seen by some observers as a battle between contrasting political and ideological systems. Already, China exceeds the West in terms of purchasing power parity, and in coming years it will do so in nominal terms. China has always been a major  recipient of foreign investment but more recently, it has also become a major outward investor.

The first of the three areas that is critical to understanding China, and where conventional wisdom is wrong, is the question of who is the world’s leading economic power. Why do Americans and Europeans say that it is China, when people in China, Latin America, Africa, the Middle East, and South Asia, all say it is the United States?  By every conventional definition, the United States is still the greatest economic power in the world. This is important because the U.S. response to the rise of China is shaped by a general loss of confidence and the view that China is the cause of America’s relative economic decline. This perception is largely attributable to the trade deficits that the United States and Europe have with China. Meanwhile, the rest of the world has an overall trade surplus with China.

The common perception is that America’s trade problems are driven by China’s trade surpluses. My book argues that this is not true. There’s no actual link between America’s deficits and China’s surpluses, even though most Americans and even some Chinese think there is. If we look at when the US trade deficit emerged, we see that it took off in the late 1990s. China’s massive surpluses only emerged in 2004 and 2005. China experienced a surplus boom in the middle 2000s because it became the center of the world’s production network after WTO membership.  So how could China have generated US deficits when the timing is way off?

Take a $1,000 iPhone; approximately 5 percent of the phone’s value is created in China through the assembly of parts that are manufactured in other Asian nations—parts that account for 50 percent of the phone’s value. The remaining share goes to Apple for distribution and intellectual property. Note that this export supposedly contributes to a $1,000 trade deficit from the US to China even though most of it actually is due to others.

A second piece of incorrect conventional wisdom is that United States foreign investment flows into China are harming U.S. competitiveness and creating job loss. In reality, the percent of U.S foreign investment that actually goes to China is only one or two percent. The remaining 98% .goes elsewhere. If you ask most Americans, or even someone in the White House, they all will say the proportion that goes to China is huge. In my book I compare American investment in China to European investment in China, because the U.S. and EU are approximately the same size economically. Why then does Europe send multiples more investment to China than the United States? After all, 15 years ago the amounts were the same.

The answer is that Europe is much more of a manufacturing center than the United States. The U.S. strength instead is in services. Even Apple has adopted a strategy where it only manages the distribution of its products and the intellectual property surrounding it. Apple does not invest in manufacturing—actual production is financed and managed by a Taiwanese company (Foxconn) in China. Therefore it costs Apple nothing—the factories are all owned by Foxconn. Apple reaps enormous profits by focusing only on the services side (design, distribution, etc.) By comparison, many European companies are still manufacturing-intensive and therefore have more interest in investing and manufacturing in China than the U.S., leading to this discrepancy in relative foreign investment numbers.

A third fallacy surrounding China is the misperception of how Chinese corruption impacts growth. The standard presumption is that corrupt countries do not grow. China is very corrupt, so why does it grow so rapidly? The answer is that in China, corruption actually drives growth instead of reducing it. This is because China is a mixed economy, which means that resources are owned and controlled by the state, but the private sector generates higher returns on those resources. The challenge in these circumstances is how to transfer the use of these resources from state ownership to the private sector.

How can this be done efficiently? Corruption does this. Instantaneously you transfer the use through informal or “grey” contracts to private interests accompanied by questionable payments or bribes. For the Chinese economy, the faster the deals go through, the more investment grows, which in turn speeds economic growth. This creates a common interest between the public and private sectors that is typically absent in other corruption afflicted systems. Elsewhere, the government official has great interest in slowing down deals to ask for higher bribes.  However in China, as a mixed economy, this incentive is removed by a shared interest for growth.

You dedicate a chapter of your book to “unbalanced growth” in China and argue that Chinese growth has not been consumption-driven enough. Could you discuss what you think the true drivers are, and what accounts for low consumption growth?

The very nature of China's growth pattern is misunderstood. Almost every established economist says that China's consumption growth is too low, investment is too high, and China must somehow rebalance. They say growth is unbalanced because of policy distortions, such as a manipulated exchange rate or a repressed interest rate. The weakness with this diagnosis of unbalanced growth is that if this has been a problem since the late 1990s, why has growth continued at such astounding rates?

Unbalanced growth is actually the key to China's rapid growth. Rather than what other economists call a policy distortion, unbalanced growth is actually the result of rural to urban migration. Development economists generally see migration as good for economic growth. What economists don't realize is that rural to urban migration also explains why consumption shares have become so low and investment shares of income so high. In subsistence farming, households spend almost everything they produce and save very little. As huge numbers of the Chinese populace move to cities for industrial jobs, their incomes triple and their savings rates skyrocket. Consumption as a share of industrial output is about 30 percent, while in agriculture it is 70 percent. When hundreds of millions of people make this shift, wages rise, savings rise, investment rises, GDP grows rapidly, and consumption increases, even if it does not grow as a relative share of output.

If you understand this dynamic, you then understand which policies are important to focus on. I recommend reform of the hukou residency policy that restricts domestic migrants from accessing public goods in cities that they move to.  This increases their savings rate above the norm for established Chinese residents in these cities. Abolishing hukou restrictions would boost consumption, by my estimates by around 2 percent of GDP. China’s current account surplus is approximately 2 percent of GDP, so this policy reform would turn China from a trade surplus to a trade neutral or deficit country. The West is quick to blame the Chinese trade surplus on exchange rates and other policy distortions, when in reality the entire surplus could be removed with this policy. Both China and the West should focus on this issue because it is a true win-win solution.

Since 2009, Chinese debt-to-GDP ratios have grown rapidly. Why is this dynamic less of a threat than many China experts acknowledge?

China’s debt-to-GDP ratio is the sum of corporate debt, household debt, and government debt all together as a portion of GDP. This ratio is currently around 250 to 260 percent of GDP. If you take the world’s hundred largest economies in the world and you line them up, you can see that, in terms of debt-to-GDP ratios, China is in the middle of the pack – higher than most developing but lower than most developed. Now think about at China’s relative stage of development. It is right in the middle. Common sense then says that China’s debt ratio is where it should be.

The more interesting question concerns less the level of Chinese debt and more the speed at which it grew. Over the last 10 years, the debt ratio in China increased by 100 percentage points. Every country that has grown at that rate has had a financial crisis. Market watchers then argue that China will certainly crash. So why is it that China survived this period of rapid debt growth without a crash?

The answer is the role of private property. China did not have a private property market until the early 2000s. The Chinese people previously had housing provided by the state, but then housing was privatized. From 2004 onwards, land prices soared, driving up property values by 600 percent over the last 10 years. This rate is unheard of in the West. If property values in the West increased by 50 to 100 percent, we would talk about property bubbles. What about 600 percent? The reason that this rise has been relatively sustainable for China is because the property values started at zero. When prices surged, houses were sold and resold, and households took out mortgages, what happened to the debt-to-GDP ratio?   Debt levels surged, but GDP did not increase, because land transfers do not count in GDP, only the labor associated with construction counts.  This process explains the bulk of the debt surge in China in the last 10 years.

You describe state-owned enterprise (SOE) liquidation as a potential method for financing a protracted bailout, should debt concerns persist. If SOEs are liquidated for that purpose, how would that affect the Chinese economy? What would be the political consequences of this reform?

China does have debt issues, and it is also facing a growth slowdown. Corporate debt is part of this problem, and most that debt is due to SOEs. This issue needs to be addressed, but the problem will not destabilize the economy. The loans that created the debt came largely from state-owned banks. This is primarily a state problem and the concern becomes the creditworthiness of the state. China has more than three trillion dollars in foreign reserves, and its government debt-to-GDP ratio is relatively low at 60 percent. Note that Japan has a 300 percent debt-to-GDP. If China’s debt situation needs to be resolved, the government has plenty of resources to handle it. While its debt burden is not an imminent threat, this pattern of state owned banks extending loans to state owned enterprises that are not financially solvent cannot continue indefinitely. The government debt problem is concentrated largely within SOEs in the heavy industries such as steel. This is significant because addressing the source of debt does not require sweeping actions. The problem-firms are concentrated within the energy and heavy industries so it is more manageable than if it was industry wide.

The other state-linked enterprises to consider are the enterprises that secure funding for the expenditures undertaken by local governments. These state-owned enterprises borrow to build roads, power plants, or schools. These debts are not really corporate debts, but rather local government debts. Again, this is not the kind of trigger for a financial crisis that we observed in the West, where there were chain-effects between debt afflicted private enterprise and financial markets more generally. China’s debt problem is really a provincial level budget issue. It persists because local governments have not been raising enough revenues in relation to their needs. China does not have property taxes, and its income taxes do not capture enough of the unofficial transactions that need to be taxed to meet the revenue needs of local governments. This problem needs to be resolved through budget reform, not banking reforms.   

What is the best scenario you can imagine for the Chinese economy in the medium term (5-7 years)?  What needs to happen for such a scenario to materialize?

China has been successful because its economic and political policies evolved to fit a changing environment. Some experts argue that reforms have slowed down in recent years.  Why has this been happening? This is because the major contradiction between the role of the state and the market in driving China’s economy has yet to be resolved. When the economy was largely driven by industry and infrastructure, this tension was less of an issue. As the Chinese economy became more services oriented, this became a problem as the state is less effective at anticipating the needs of a services oriented economy

In promoting urbanization, for example, the priorities of the state and the signals sent by the market may be in conflict.  The state wants to tell people where they can live but the market determines where the jobs are. When the country relied largely on agriculture, this did not matter as much because almost any urban center was more productive than agriculture. Now, it's more difficult because the mega-cities like Beijing, Shanghai, and Shenzhen are off limits to new migrant. Migrants are told to go to smaller cities. Productivity, however, is much higher in the big cities. The market then suffers because people cannot move there.

In dealing with SOEs, it is perfectly reasonable for the government to want to protect SOEs in strategic sectors, even if these firms generate relatively lower returns. However, there are also SOEs that operate in activities that they should not be in. This significantly harms Chinese growth prospects by displacing potentially more productive private firms.

The final area of concern is how to deal with corruption. If corruption has been a force for driving growth, and the state is now attempting to curb corruption, this will result in slower growth in the absence of policy reforms. The Western recommendation is to promote the rule of law, but this takes a lot of time and is especially challenging in emerging market economies. China is impatient. It wants to move to high income levels soon, but its public institutions are still weak and its rule of law underdeveloped.  Meanwhile, the state can potentially take on a more interventionist role while efforts are underway to strengthen the rule of law and institutions. But such initiatives are viewed negatively in the West because they expand the authority of President Xi Jinping as exemplified in the creation of Communist Party led supervisory committees and removal of term limits for the Presidency. Most observers thus argue that these policies will work out badly. I am still unsure. Time and time again we are wrong in thinking that Chinese policies are “unconventional” and therefore doomed to fail.

Tobin Hansen CMC '20Student Journalist
Image description: North Korea’s musical ensemble Samjiyon Orchestra had its second performance in Seoul, South Korea on February 11, 2018. On this night, K-pop girl group Girl’s Generation member Seohyun presented audiences a pleasant surprise by making an appearance on the stage.
Attribution: Kim Jinseok (Official photographer of the Blue House, Republic of Korea), Blue House (the executive office of the Republic of Korea head of state, the President of the Republic of Korea) [KOGL (http://www.kogl.or.kr/open/info/license_info/by.do)], via Wikimedia Commons
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